Rolling the Currency Dice: Investing in International Bond Funds
by John Markese
The search for yield and the weak U.S. dollar have prompted individual investors to set their sights abroad, and to consider investing in foreign bond mutual funds. International bond mutual funds, however, have their own unique set of risks. And these risks are magnified by the often rapid ebb and flow of international currency markets.
Yields may be higher in other countries and the dollar may be swooning, but a careful look at international bond mutual funds is in order before you let your money travel overseas.
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The two primary risks of investing in foreign fixed-income securities are:
- Credit Risk: The riskiness of the issuers of the individual securities in the portfolio, and
- Currency Risk: The risk that the currency in which the se
curities are denominated will change in value relative to the U.S. dollar.
There is also a more subtle risk for individual investors: understanding the sometimes arcane portfolio holdings of these funds, which may include futures, options, repurchase agreements, loan participations and asset-backed debt such as collateralized mortgage obligations.
And in terms of holdings, it can be surprising to what degree some of these international bond funds are actually invested in U.S. securities—contrary to the purpose driving most individual investors to international bond mutual funds in the first place.
Table 1 lists international bond mutual funds that can be also found in the “Individual Investor’s Guide to the Top Mutual Funds” and in the extended listings of mutual funds on AAII.com.
There are three distinct types of international bond funds in Table 1:
- Emerging markets, and
Within each section, the funds are listed based on the amount of their investments that are in U.S.-dollar-denominated securities; the funds with the lowest percentages in U.S.-dollar-denominated securities are at the top of the list in each section.
Traditional international bond funds usually hold bonds issued or guaranteed by foreign governments of developed countries—for example, the United Kingdom, Germany, and Canada. They may also hold the debt of organizations such as the World Bank and the European Economic Community, as well as the debt of foreign banks and corporations.
Bonds issued by developed countries (both governments and corporations) also represent distinct currencies—for example, bonds issued by the U.K., German and Canadian governments represent the British pound, the euro, and the Canadian dollar.
For that reason, one issue to keep an eye on when examining a traditional foreign bond fund concerns foreign currency exposure and hedging, particularly since one of the investment incentives to invest in international bond funds is foreign currency diversification—holding securities denominated in an array of currencies other than the U.S. dollar.
International bond mutual funds often have the ability to hedge against currency changes as part of their investment policies and practices. There are two types of hedges: cross and direct.
Cross hedges may be instituted by an international bond fund when one foreign currency is expected to weaken in comparison to another represented by the securities in the portfolio. If forecast and applied appropriately, the cross hedge can enhance return for a U.S. investor.
The direct hedge—when a foreign currency is hedged directly against the U.S. dollar—defeats the purpose of investing in an international bond mutual fund to counteract the weakening dollar in the first place.
Individual investors seeking to hedge against the weakening U.S. dollar should avoid international bond funds that employ direct hedges or do not hedge out of the currency risk of any holdings of securities that are denominated in U.S. dollars.
However, if your concern is a weak U.S. dollar, then an appropriate international bond mutual fund is one that has the objective of little net exposure to the U.S. dollar no matter what hedging the fund does.
Emerging Market Funds
Emerging market international bond funds have structures that are similar to those of the traditional international bond funds. However, the international securities they invest in are issued by governments and corporations in developing nations.
For example, where the traditional American Century International Bond fund is invested primarily in the securities of the United Kingdom, Germany and Japan, the emerging markets Payden Emerging Markets Bond fund is primarily invested in securities from Brazil, Mexico and the Philippines.
The three international bond funds reported separately at the bottom of Table 1 are currency funds.
How do these work? The approaches vary.
The Rydex Weakening Dollar 2x Strategy fund has an investment objective of twice the inverse performance of the U.S. dollar index (the U.S. dollar index measures the dollar against a basket of foreign currencies). That means that if the U.S. dollar index were to weaken 10%, the fund’s goal is to provide a 20% gain, and conversely if the U.S. dollar index strengthens by 15%, the fund would experience a 30% loss. To achieve this goal, the Rydex fund employs derivatives such as swaps, options and futures contracts.
The Merk Hard Currency fund takes a much different tack, investing in a basket of currencies by buying primarily short-term Treasury bills and notes of countries with, in their opinion, “sound” monetary policy. These countries include Switzerland, Germany, Canada, Sweden and the U.K. The fund also holds gold-related investments that tend to inversely track the U.S. dollar. Of the three currency bond funds, the Merk Hard Currency fund generates above-average yields while the Rydex Weakening Dollar 2x Strategy fund produces no meaningful yield.
Table 1 reports the returns, risk and other pertinent investment characteristics for this group of foreign bond funds.
Over the last five years, the highest average annual returns have been generated mostly by the emerging markets international bond funds. The T. Rowe Price Emerging Markets Bond fund returned an average of 13.2% annually over the last five years, followed by the DWS Emerging Markets Fixed Income fund at 12.8% and the Fidelity New Markets Income fund at 12.4%.
Most recently, for the full-year 2007, the pure inverse dollar currency play funds clearly performed the best, as the dollar significantly weakened in 2007.
Traditional international bond funds posted relatively lower returns than the emerging market international bond funds over five years, with the T. Rowe Price International Bond fund returning 8.5% on average, and the American Century International Bond fund returning 9.1%.
By comparison, the average U.S. government intermediate maturity bond fund returned 4.5% annually on average over the same five years.
Category and Total Risk
In the first group of funds in Table 1 the category risk numbers generally decline as the percentage invested in U.S. securities rises.
The highest category risks (where 1.0 indicates the average risk for the category and risk measures the volatility of returns) belong to the emerging market bond funds, and the traditional international bond funds that have little or no U.S. securities (those toward the top of the list).
The currency funds, at the bottom of Table 1, all have relatively high category risk, with the Rydex Weakening Dollar 2x Strategy fund exhibiting over twice the category risk with an index figure of 2.33.
The total risk index compares a fund to all other mutual funds—bond, stock, domestic and international alike. All these funds, with the exception of the Rydex Weakening Dollar 2x Strategy have total risk index numbers below average—less than 1.0. Once again, the more invested in the U.S., the less the total risk.
Expense ratios are particularly important for bond funds because expenses eat yield. The higher the expense ratio, the lower the yield for an individual fund.
U.S. government bond funds should be expected to have expense ratios below 0.75%. International investments are more expensive to manage, and international stock funds have higher expense ratios than their domestic counterparts.
For these international bond funds, expense ratios above 1.00% should be considered high—the 1.15% expense ratio for DWS Emerging Markets Fixed Income fund, for example.
All the currency funds have exceptionally high expense ratios due to their extremely active management style and the use of complex derivatives such as options and futures. (The T. Rowe Price Spectrum Income fund reports a 0.00% expense ratio because it is a fund of funds and does not charge expenses in addition to the individual funds’ expense ratios.)
Generally, longer maturities create greater risk as longer-term bonds are more volatile than shorter-term bonds when interest rates change.
The average maturity for the fixed-income securities held in the portfolios of these foreign bond funds varies from a short-term of 2.7 years (for the Payden Global Short Bond fund) to 14.9 years (for the DWS Emerging Markets Fixed Income fund).
A few funds, such as Fidelity New Markets Income fund, do not report average maturity for their portfolios. And for the currency funds, maturity is irrelevant.
The range in yield for these funds is wide—from a high of 7.8% for the T. Rowe Price Emerging Markets Bond fund to effectively 0.0% for the Rydex Weakening Dollar 2x Strategy fund.
Surprisingly, a traditional international bond fund, T. Rowe Price International Bond fund, offers one of the lowest yields, at 3.3%. By comparison, the average U.S. government bond fund has a yield of 4.2%.
Top Country Holdings
Finally, and rather telling, Table 1 provides the top three country holdings for each fund, with the exception of the currency funds, along with the percentage of the total portfolio invested in the securities of each country.
While all of the traditional and emerging markets international bond funds invest globally, a surprising number of these funds have significant investment in the U.S. For the Payden Global Short Bond fund with 76.5% invested in the U.S., the fund may not be as global as an investor might expect.
If you are an investor seeking higher yields internationally or trying to offset a declining U.S. dollar, or both, proceed with caution when considering an international bond fund. The yields can be higher internationally, but so are the risks.
If you are looking for a foreign currency haven among the traditional international bond funds, many of these funds have such high proportions of their portfolios invested in the U.S. that the implicit currency hedge of investing internationally can be significantly nullified.
And if you are seeking a pure currency hedge, the currency international bond funds are high risk as well as one-dimensional, and while the dollar seems unable to muster much strength recently, a turnaround by the U.S. dollar would turn the currency funds into high negative return investment machines.
Another gamble is that many of these funds employ complex strategies that are sometimes mystifying to the individual investor, and that cross many borders. Investing in different countries brings into play other sets of political, social and economic risks that may or may not be compensated sufficiently with additional returns.
All in all, unless you thoroughly understand the strategies and risks of these international bond funds—and the yield, total return potential, dollar protection and diversification benefits appear to be proportionate to the additional risk compared to investing in U.S. bond funds—then don’t place such a high bet for your fixed-income investments.